Investing in Retail: Understanding the Cash Conversion Cycle

Investing in Retail: Understanding the Cash Conversion Cycle

One of the best ways to distinguish excellent retailers from average or below average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

Figure: The cash conversion cycle

= Days in Inventory + Days in Receivables - Days Payable Outstanding

= 365/Inventory turnover + 365/Receivables turnover - 365/Payables turnover

Where,
Inventory turnover = Cost of goods sold/Inventory
Receivables turnover = Sales/Accounts receivable
Payables turnover = Cost of goods sold/Accounts payable

Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns).

The best-case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier. Wal-Mart is one of the best in the business at this: 70 percent of its sales are rung up and paid for before the firm even pays its suppliers.

Looking at the components of a retailer's cash cycle tells us a great deal. A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favor. This leads to excess inventory, clearance sales, and, eventually, declining sales and stock prices.

Days in receivables is the least important part of the cash conversion cycle for retailers because most stores either collect cah directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price. Retailers don't really control this part of the cycle too much.

However, some stores, such as Sears and Target, have brought attention to the receivables line because they've opted to offer customers credit and manage the receivables themselves. The credit card business is a profitable way to make a buck, but it's also very complicated, and it's a completely different business from retail. We're wary of retailers that try to boost profits by taking on risk in their credit card business because it's generally not something they're very good at.

If days in inventory and days in receivables illusrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they're one of the few (if not the only) games in town. For example, 17 percent of P&G's 2002 sales came from Wal-Mart. The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retai has a huge advantage when ordering inventory: It can push for low prices and extended payment terms.

Home Depot finally started taking advantage of its competitive position by squeezing suppliers in 2001 and 2002. Days payable outsanding for the home improvement titan has historicaly been around 25. In 2001, the figure hit 33 days, and by 2002, it exceeded 40 days. By holding on to its cash longer and reducing short-term borrowing needs, Home Depot increased its operating cash flow from an average of $2.4 billion from 1998 to 2000 to $5.6 billion from 2002 to 2003.